ETFs add security to holding equities.

The arrival of exchange traded funds has added another option for those who wish to invest in passive investment strategies. Paul Ali and Martin Gold examine the operation of these funds and their potential benefits.

Late last year State Street Global Advisors and the Australian Stock Exchange announced they had signed an agreement to develop the first Australian exchange-traded funds (ETF). This follows similar announcements in the Asia-Pacific region, regarding ETFs in Singapore and Japan.

Early this year Barclays Global Investors (BGI) also threw its hat into the ring indicating it would also roll out ETFs to local investors based on the success of the funds in the United States.

The development of these new style funds has been delayed awaiting taxation clearance in Australia but the recent announcement that the proposed collective investment vehicle (CIV) legislation will not be enacted appears to pave the way for local offerings.

ETFs are "hybrid" mutual funds that deliver the coverage of index-tracking unit trusts with the tradeability of listed investment companies, whilst overcoming the main drawbacks of those two vehicles for investors. ETFs are also challenging the rationale for index-tracking unit trusts given their extremely low operating expenses, and more efficient tax structures.

The current market value of the ETFs now exceeds US$60 billion, with the S&P 500 SPDR fund tipping the scales as the largest fund with US$25.5 billion in assets (see table).

ETFs generally aim to track the price and income returns of:

- a sector index that tracks a market sub-set according to industry, market size or geography; or

- a broadly-based index (eg S&P 500 or FTSE-100);

- a basket of stocks.

Like conventional index-tracking unit trusts, sector and broadly-based index ETFs comprise all of the shares of the relevant index or fewer using "sampling" techniques, where the fund invests in a sample of shares in the index, which have a similar investment profile.

In the case of Barclay's iShares, the ETF, although normally fully invested, must invest at least 90% of assets in physical shares with the balance invested in index futures. Generally, ETFs are not actively managed, instead, re-balancing is used to keep the investment portfolio closely correlated with the relevant index.

ETFs are not market timer strategies and therefore cash buffers are not kept and holdings are not altered during, or in anticipation of, market declines.

A basket ETF is a passively managed portfolio of securities that doesn't track a specific index or market. Merrill Lynch offers basket ETFs in its HOLDRS series ("HOLDRS" stands for Holding Company Depository Receipts).

These ETFs hold 20 or 50 of the largest and most liquid US-listed companies involved in a sector or market. Like index ETFs, basket ETFs are primarily passive portfolios that only change where a significant event occurs such as a delisting, merger or removal by the trustee.

ETFs have also been designed to solve some of the drawbacks associated with conventional unlisted trusts and listed investment companies.

In a conventional unit trust, investors redeem their units off-market. The trustee is required to buy-back their units for cash. This has two major drawbacks. First, the net asset value (NAV) of a unit trust is typically calculated daily after the close of trading. Consequently, investors' transactions are generally executed only once a day after the close of the market.

Secondly, the trustee may be forced to sell portfolio stocks to pay redemptions. This can trigger capital gains tax liabilities for all investors, not just those exiting the fund.

A listed investment company avoids the requirement to pay cash redemptions to investors. Investors who wish to exit can sell their shares on the stock exchange, where pricing and trading are continuous.

However, in common with other stocks, investment company shares can trade at significant discounts or premiums to NAV, due to factors such as market liquidity, perceptions of management, and economic factors. In addition, market conditions can also affect the ability of investors to transact large parcels of shares without incurring significant transaction costs.

The dual trading structure of ETF's combines the favourable attributes of open-ended unit trusts and listed investment vehicles. The ETF therefore gives investors two methods for investing and redeeming from the fund.

Investors can buy or sell an ETF at any time during a trading day like any other stock. Large investors can also create ETF shares by depositing a portfolio of shares with the trustee that closely resembles its published portfolio holdings (i.e. the relevant index or basket).

These in-kind deposits and redemptions must be made in large quantities and occur via authorised participants such as brokers set up to transact directly with the fund.

Investments and redemptions can therefore be made by transferring shares "in-kind" to or from the ETF, or by trading the ETF on the stockmarket through a broker.

ETF investors can turn in their certificates and receive the underlying shares, or sell the ETF on the stock exchange at any time during the trading day without forcing the sale of the underlying share portfolio. This avoids triggering a capital gains tax liability for all investors.

In the case of market makers and institutional investors, the in-kind creation and redemption mechanism of an ETF avoids the problems with trading large parcels on-market. Further, because the in-kind transactions are made at NAV, ETFs do not generally trade at sustained discounts or premiums to NAV due to the arbitrage activity of authorised participants.

A significant advantage afforded by the ETF structure is the efficiency of the portfolio strategy. Since ETFs do not have to anticipate cashflows from investors, an ETF's portfolio is normally fully invested. ETFs can thereby minimise the "cash drag" on performance experienced by conventional index funds that keep some cash aside to meet investor redemptions.

ETFs also give investors the ability to control their individual capital gains position in the case of in-kind transactions. The in-kind investment structure means that, like on-market transactions in ETFs, the taxation position of individual investors should not be affected by the in-kind transactions of other investors in the ETF.

In the US, for example, in-kind deposits and subsequent redemptions by investors do not trigger a tax liability for the ETF, although the exiting investors may incur a taxable gain or loss.

ETFs have the potential to render conventional index funds obsolete as they deliver indexing strategies with significantly lower operating costs. Importantly, ETFs also offer investors a more tax-efficient structure providing taxation control that is lost when investing via a conventional unit trust.

In contrast to conventional index funds that do not offer distribution incentives, the growth of ETFs seems to be assured by intermediaries who can earn commissions by distributing and transacting these funds for clients.

Martin Gold is manager, investment services with Royal SunAlliance

Paul Ali is a director with MFAS Investment Advisors

Table

Top 10 Index Shares By Assets

RankNameApproximate Net Assets ($US bn)

1 S&P 500 SPDR $25.5

2 Nasdaq-100 Index Tracking Stock $23.6

3 S&P 400 MidCap SPDR $3.9

4 DJIA DIAMONDS $2.4

5 iShares S&P 500 $2.3

6 Select sector SPDR-Technology $1.07

7 iShares MSCI-Japan $0.65

8 Select Sector SPDR-Financial $0.5

9 iShares Russell 2000 $0.39

10 iShares Russell 3000 $0.3

Source: BGI. As at December 31, 2000